Written by

Dr. Ira Kalish

Published

August 22, 2013

Financial liberalization

In the aftermath of China’s credit market near-crisis in June, there has been considerable discussion about what the country must do to prevent future crises while, at the same time, shifting toward a more sustainable financial path. Thus it is notable that China has taken a first tentative step in the direction of financial market liberalization.

First, some background: Until recently, China set the benchmark lending rate at 6.0 percent and the benchmark deposit rate at 3.0 percent. The government allowed banks to lend money at 70 percent of the benchmark lending rate, and allowed banks to pay depositors up to 110 percent of the benchmark deposit rate. By establishing these limits, the government guaranteed the banks a healthy profit margin. Yet these controls have distortionary effects on the economy. A floor on lending rates denies many borrowers of credit. A cap on deposit rates means that savers get a limited return and have an incentive to seek higher returns elsewhere—such as in property speculation.

In July, the government announced that it will remove the floor on bank lending rates, which previously had been set at 70 percent of the benchmark lending rate. It did not, however, do anything to liberalize deposit rates. Most analysts see liberalization of deposit rates as more critical to rectifying the imbalances and inefficiencies of financial markets. Deposit rate liberalization would remove the incentives behind the massive growth of the shadow banking system. It is reported that the central bank supported deposit rate liberalization, but failed to win this battle—at least for now. The state-run banks clearly have an incentive to retain the deposit rate rules. As for the lending rate liberalization, few banks currently lend at the floor rate, so eliminating the floor probably won’t have much of an impact on lending activity. Still, this action will boost competition between banks. It also can be seen as a signal by the authorities that they intend to move in the direction of financial market liberalization. The question is how soon and how far they will go. One thing we know is that the government is determined to make the currency internationally convertible. This has been discussed quite publicly. Yet this cannot happen absent interest rate liberalization.

Interestingly, although economic growth in China has decelerated, employment growth has accelerated.

Growth

There has been further news lately that the Chinese economy is growing more slowly than had been expected. The purchasing manager’s indices (PMIs) for manufacturing worsened in July, suggesting that activity in the sector is declining at an accelerating pace. China’s misfortune pulled down neighboring countries, including Taiwan, South Korea, and Australia, all of which saw worsened PMIs in July.

The PMIs followed reports from China’s government about GDP growth for the second quarter. The headline suggests that growth slowed down. But the reality is a bit different. China reports growth based on the percentage change from a year earlier. By this measure, growth did indeed slow from 7.7 percent in the first quarter to 7.5 percent in the second quarter. However, a more useful measure is to look at the change from quarter to quarter at an annual rate. By this measure, growth accelerated from 6.6 percent in the first quarter to 7.0 percent in the second quarter. This is the same measure that the US government uses to report US GDP growth. The Chinese don’t do this, but the quarterly change can nonetheless be calculated by economists. The data suggest that China continues to grow at a relatively slow pace, but growth did accelerate a bit in the second quarter. Exports performed poorly, and domestic demand was relatively weak. Most analysts expect that growth will remain subdued for the remainder of the year.

Thankfully, there was some encouraging data from the Chinese government recently. Retail sales increased 1.26 percent from May to June. This was up from 1.15 percent in the previous month. Industrial production was up 0.68 percent from May to June, as opposed to 0.61 percent in the previous month. Finally, fixed asset investment was up 1.51 percent from May to June, up from 1.43 percent in the previous month.

Premier Li Keqiang responded to the news about modest GDP growth by saying that the government will seek to avoid “wide fluctuations” in economic activity. He also said that the government should create a “scientific macroeconomic policy framework” that would provide the market with “stable predictability.”1 While somewhat vague, this statement can be interpreted to mean that, while the government is comfortable with slower growth, it wants to stabilize growth and avoid volatility.

Interestingly, although economic growth in China has decelerated, employment growth has accelerated. It was reported that in the first six months of 2013, China created 7.25 million new jobs, more than in the corresponding period in 2012. One of the biggest fears of the Chinese leadership is a rise in unemployment. They probably will be willing to absorb a slowdown in growth as long as entrants to the labor force can find work. A Chinese government official said that, going forward, more jobs will need to be created in the service sector, emerging industries, and the private sector.

The government has boosted prices of natural gas for the first time in three years. The goal is to encourage more development of natural gas through unconventional means. This means recovering so-called “tight gas” from shale rock and methane beds. The goal is to triple gas output by 2020. China is the world’s largest energy consumer and has become a significant importer of energy. Further development of domestic sources will require more market pricing.